International trade and international finance explorations of contemporary issues

Malabika Roy · Saikat Sinha Roy Editors

International
Trade and
International
Finance
Explorations of Contemporary Issues


International Trade and International Finance


Malabika Roy Saikat Sinha Roy
•

Editors

International Trade
and International Finance
Explorations of Contemporary Issues

123


Editors
Malabika Roy
Department of Economics
Jadavpur University
Jadavpur, Kolkata, West Bengal
India

ISBN 978-81-322-2795-3
DOI 10.1007/978-81-322-2797-7

Saikat Sinha Roy
Department of Economics
Jadavpur University
Jadavpur, Kolkata, West Bengal
India

ISBN 978-81-322-2797-7

(eBook)

Library of Congress Control Number: 2016937967
© Springer India 2016
This work is subject to copyright. All rights are reserved by the Publisher, whether the whole or part
of the material is concerned, specifically the rights of translation, reprinting, reuse of illustrations,
recitation, broadcasting, reproduction on microfilms or in any other physical way, and transmission
or information storage and retrieval, electronic adaptation, computer software, or by similar or dissimilar
methodology now known or hereafter developed.
The use of general descriptive names, registered names, trademarks, service marks, etc. in this
publication does not imply, even in the absence of a specific statement, that such names are exempt from
the relevant protective laws and regulations and therefore free for general use.
The publisher, the authors and the editors are safe to assume that the advice and information in this
book are believed to be true and accurate at the date of publication. Neither the publisher nor the
authors or the editors give a warranty, express or implied, with respect to the material contained herein or
for any errors or omissions that may have been made.
Printed on acid-free paper
This Springer imprint is published by Springer Nature
The registered company is Springer (India) Pvt. Ltd.

Foreword

The present volume is a collection of articles on various aspects of international
trade and international finance, written by a selected group of researchers who have
specialized in the respective fields. The planning of this volume was mooted at the
meeting of advisory committee of the Centre for Advanced Studies (CAS) of the
Department of Economics, Jadavpur University. Since CAS has sponsored a variety
of workshops and seminars and hosted visiting fellows, the external experts of the
CAS, Profs. Dilip Nachane (former Director, Indira Gandhi Institute of
Development Research, Mumbai) and Ramprasad Sengupta (formerly of Jawaharlal
Nehru University, New Delhi) suggested that we collate important papers in two
volumes to be contributed by the visitors as well as Jadavpur’s own faculty. The
reason for planning two volumes is to accommodate the five thrust areas we have in
the CAS, namely International Trade, Finance, Resource and Environment, West
Bengal Economy and Public Policy related to social sector. The idea is to produce a
monograph which will help the readers with some survey papers along with some
state-of-the-art research in relevant fields. The present volume International Trade
and International Finance: Explorations of Contemporary Issues edited by my two
junior colleagues, Malabika Roy and Saikat Sinha Roy, who are themselves specialists in the subject matters included in the book, has a very well-thought collection of topics covered under the purview of the book. The papers selected will be
of great help for the teachers and researchers in the subject on the one hand and on
the other, it would certainly be a handy reference for policy planners and practitioners. I must thank the efforts of the editors who spared their valuable time to
make the volume useful and interesting. I have faith that the purpose of publishing
this volume will be totally fulfilled and we will be having increasing returns to
knowledge after reading the volume.
Ajitava Raychaudhuri
Professor and Coordinator, Centre for Advanced Studies
Department of Economics, Jadavpur University, Kolkata, India

v


Contents

Part I

Recent Developments in Trade Theory and Empirics

The “New-New” Trade Theory: A Review of the Literature . . . . . . . . .
Priya Ranjan and Jibonayan Raychaudhuri

3

Time Zones and FDI with Heterogeneous Firms. . . . . . . . . . . . . . . . . .
Toru Kikuchi, Sugata Marjit and Biswajit Mandal

23

MNEs and Export Spillovers: A Firm-Level Analysis of Indian
Manufacturing Industries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Maitri Ghosh

33

IPR Regulatory Policy, Commercial Piracy, and Entry Modes
of MNC: A Theoretical Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Nilanjana Biswas Mitra and Tanmoyee Banerjee Chatterjee

49

Part II

International Trade and Institutions

International Trade and the Size of the Government . . . . . . . . . . . . . .
Rajat Acharyya
The Effects of Corruption on Trade Flows:
A Disaggregated Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Subhayu Bandyopadhyay and Suryadipta Roy

77

97

Enlargement Decisions of Regional Trading Blocs . . . . . . . . . . . . . . . . 117
Sunandan Ghosh
Deal Breaker or the Protector of Interests of Developing Countries?
India’s Negotiating Stance in WTO . . . . . . . . . . . . . . . . . . . . . . . . . . . 159
Parthapratim Pal
Is WTO Governed Trade Regime Sufficient for Export Growth? . . . . . 179
Saikat Sinha Roy and Pradyut Kumar Pyne

vii


viii

Part III

Contents

Issues in Trade, Trade Policy and Development

Export Performance in Textile and Garments with China
as a Competitor: An Analysis of India’s Situation from the Perspective
of Structure-Conduct-Performance Paradigm . . . . . . . . . . . . . . . . . . . . 201
Sarmila Banerjee, Sudeshna Chattopadhyay and Kausik Lahiri
Impact of Trade Liberalization on Indian Textile Firms:
A Panel Analysis. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 229
Subhadip Mukherjee and Rupa Chanda
Trade, Infrastructure and Income Inequality in Selected Asian
Countries: An Empirical Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . 257
Ajitava Raychaudhuri and Prabir De
A Theoretical Model of Trade, Quality of Health Services
and Signalling. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 279
Kausik Gupta and Tonmoy Chatterjee
Smuggling and Trafficking of Workers: A Brief Review
and Analysis of the Economics of Illegal Migration . . . . . . . . . . . . . . . 295
Saibal Kar
Impact of Trade Restriction on Child Labour Supply
and the Role of Parents’ Utility Function: A Two Sector
General Equilibrium Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 315
Biswajit Chatterjee and Runa Ray
Part IV

Issues Related to Foreign Investment Flows

The Determinants of Foreign Direct Investment:
An Analytical Survey . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 333

Chaitali Sinha and Kunal Sen
Foreign Direct Investment, Capital Formation, and Growth . . . . . . . . . 363
Prabirjit Sarkar
Foreign Direct Investment and Macroeconomic Indicators in India:
A Causality Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 373
Basabi Bhattacharya and Jaydeep Mukherjee
Part V

Issues Relating to Globalization, Financial Markets
and Financial Instruments

Exploratory Study of Select Commodity and Equity Indices
Around the Meltdown of 2008 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 387
Diganta Mukherjee and Arnab Mallick


Contents

ix

An Empirical Investigation of Volatility Clustering, Volatility
Spillover and Persistence from USA to Two Emerging Economies
India and China . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 405
Ayanangshu Sarkar and Malabika Roy
Imbalances, Local and Global, and Policy Challenges
in the Post-Crisis World . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 429
Soumyen Sikdar
Testing Non-linearity in Emerging and Developed Markets. . . . . . . . . . 437
Kousik Guhathakurta, Basabi Bhattacharya and A. Roy Chowdhury
Part VI

Issues Related to Foreign Exchange Market

Foreign Exchange Markets, Intervention, and Exchange
Rate Regimes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 469
Ashima Goyal
Global Foreign Exchange Market: A Crisis Analysis . . . . . . . . . . . . . . 493
Gagari Chakrabarti
The Impossible Trinity: Where Does India Stand? . . . . . . . . . . . . . . . . 511
Rajeswari Sengupta
Part VII

Issues Related to Financial Institutions

Guaranty Funds and Moral Hazard in the Insurance Industry:
A Theoretical Perspective . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 527
C. William Sealey, John M. Gandar and Sumon C. Mazumdar
Performance of Aggregate Portfolios of Equity Mutual Funds:
Skill or Luck? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 547
Rama Seth and Kamran Quddus
Foreign Bank Presence and Financial Development in Emerging
Market and Developing Economies: An Empirical Investigation . . . . . . 565
Sasidaran Gopalan
Banks, Financial Derivatives, and Crises:
A Fourth-Generation Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 585
Romar Correa


Introduction

International trade and international finance have always been important areas of
research in economics. With globalization, the nature, importance, and scope of the
subjects have changed and the horizon has expanded manifold. Instead of treating
international trade and international finance as two disjoint areas of study, the
present volume brings together a collection of essays from both the fields, sometimes overlapping across the two areas. The volume, while focusing on the recent
developments and frontiers of research in international trade and international
finance, also emphasizes the inherent integrated nature of the two subjects.
Theory and empirics in international trade is founded on microeconomic principles highlighting the gains from trade through specialization and exchange as a
country moves from autarky to free trade. The traditional theoretical notion of
comparative advantage evolved to include nuances of imperfect competition and
product differentiation. This has again recently given way to “New-New Trade
Theory”, which centres on the concept of heterogeneity of firms. This latest
development in trade theory is an important direction of trade research especially
during globalization. With globalization, new sectors have emerged important and
the modes of trade considerably vary from that in the past. Further, new institutions,
both global and domestic, have emerged and have significant implications for trade.
In this volume, the theoretical and empirical papers included deal with recent
advances in the subject, emergence of new sectors and institutions in shaping up
trade during globalization.
International finance primarily developed from macroeconomics to address the
same issues about equilibrium level of income, growth of output and employment
and effects of monetary and fiscal policies—but in an international context, when
more than one economy are interacting with each other in the sphere of trade and
finance involving more than one currencies. It is not surprising that traditionally, the
issues addressed in international finance were balance of payments and related
policies, foreign exchange market and foreign exchange management, global capital
markets and cross-border flow of funds, international financial systems and their
management. However, globalization brought about not only an integration of
financial markets but also an integration of financial institutions. So in the present
xi

xii

Introduction

volume we have included essays that address issues related to international financial
institutions along with essays dealing with traditional issues on foreign exchange
markets and international financial markets.
The present volume contains 28 essays divided into seven thematic parts. Rather
than dividing the parts in line of international trade and international finance, we
have divided the parts according to thematic uniformity thus establishing a close
link between international trade and international finance. However, the chapters
included in Parts I–V focus more on issues related to international trade, whereas
chapters included in Parts V–VII lean more towards issues related to international
finance.
Part I covers works on recent developments in international trade theory and
empirics. Chapter “The “New-New” Trade Theory: A Review of the Literature” by
Priya Ranjan and Jibonayan Raychaudhuri is an account of the developments and
progress in “New-new” trade theory models and empirical research centred on the
seminal work of Melitz (2003). This chapter also discusses the policy implications
and welfare implications of trade liberalization in this context. In Chapter “Time
Zones and FDI with Heterogeneous Firms”, Toru Kikuchi, Sugata Marjit and
Biswajit Mandal develop a model on the role of FDI in the context of heterogeneous firms situated in different time zones. It is shown that firms undertaking FDI
have higher productivity than non-FDI firms, and the foreign subsidiaries of
high-productivity firms serve the home market. In Chapter “MNEs and Export
Spillovers: A Firm-Level Analysis of Indian Manufacturing Industries”, in an
empirical analysis, Maitri Ghosh looks into the role of firm heterogeneity in export
spillovers in the presence of FDI. It is found that firm heterogeneity, measured in
terms of productivity and sunk cost, is critical to explaining export spillovers in the

presence of multinationals. In contrast to the other chapters in this part, Chapter
“IPR Regulatory Policy, Commercial Piracy and Entry Modes of MNC: A
Theoretical Analysis” by Nilanjana Biswas (Mitra) and Tanmoyee Banerjee
(Chatterjee), relates IPR regulation regime chosen by LDC government to the mode
of entry of the MNC: fragmentation or full technology transfer, in the presence of
commercial piracy. It is found that entry in this case depends on the transport cost
and monitoring.
The second part on international trade and institutions covers issues like trade
openness and the size of government, issues related to bilateral, regional and
multilateral trade. In Chapter “International Trade and the Size of the Government”,
using a theoretical framework Rajat Acharyya shows that under certain conditions
pertaining to the non-traded public good, trade liberalization in terms of tariff
reduction necessarily increases absolute size of the government. The relative size
of the government expands when the value of the price elasticity of the public good
is small though not less than unity. Corruption in trading countries at the importer
level as well as exporter level plays an important role in bilateral trade. In Chapter
“The Effects of Corruption on Trade Flows: A Disaggregated Analysis”, Subhayu
Bandopadhyay and Suryadipta Roy investigate the impact of importer level and
exporter level corruption on bilateral exports for 27 sectors of 100 countries during
1984–2004. The other chapters in this part deal with regional trading blocs or issues


Introduction

xiii

related to WTO. Using an oligopolistic framework in Chapter “Enlargement
Decisions of Regional Trading Blocs”, Sunandan Ghosh shows the possibilities of
and nature of equilibrium in the expansion or consolidation of regional trading
blocs in the presence of technology and market asymmetries between countries. The

conclusions are of importance for emerging market economies, which are a part of
an existing regional trading arrangement seeking expansion or consolidation. In
Chapter “Deal Breaker or the Protector of Interests of Developing Countries?
India’s Negotiating Stance in WTO”, Parthapratim Pal, delineates India’s engagements in Doha Round of trade talks in the light of the experience with the WTO
regime and changes in global trade including proliferation of RTAs along with
rising global commodity prices. The last chapter in this part, an empirical paper by
Saikat Sinha Roy and Pradyut Kumar Pyne on “Is WTO Governed Trade Regime
Sufficient for Export Growth?”, highlights that a WTO-governed trade regime is not
sufficient for export growth across countries.
In the third part, which focuses on trade and development, there are theoretical as
well as empirical papers. Chapters “Export Performance in Textile and Garments
with China as a Competitor: An Analysis of India’s Situation from the Perspective of
Structure-Conduct-Performance Paradigm” and “Impact of Trade Liberalization on
Indian Textile Firms: A Panel Analysis” both deal with different aspects of trade in
India’s textiles sector, a very important sector in terms of output, wide range of
technology used, foreign exchange earnings and employment. In Chapter “Export
Performance in Textile and Garments with China as a Competitor: An Analysis of
India’s Situation from the Perspective of Structure-Conduct-Performance Paradigm”,
Sarmila Banerjee, Sudeshna Chattopadhyay and Kausik Lahiri analyse textiles
exports from India as compared to that from China, which followed a more aggressive
approach in terms product and market diversification. The chapter relates such
international price and non-price competitiveness to policies adopted in these
countries. On the other hand, in Chapter “Impact of Trade Liberalization on Indian
Textile Firms: A Panel Analysis” Subhadip Mukherjee and Rupa Chanda show the
impact of trade liberalization on improvements in profitability, sales and import of
raw materials. In this chapter, the effect of trade liberalization is found to be stronger
through the import sourcing channel. The impact of merchandise trade on income
inequality has been significant. In Chapter “Trade, Infrastructure and Income
Inequality in Selected Asian Countries: An Empirical Analysis”, Ajitava
Raychaudhuri and Prabir De show that trade openness and infrastructure have significant impact on income inequality across countries in the Asia-Pacific region, and

country-specific factors turn out to be important determinants of trade openness and
income inequality. The chapter also establishes persistence in trade openness and
income inequality across these countries.
The other chapters in this part deal with issues related to services trade, labour
movements and development. Chapter “A Theoretical Model of Trade, Quality of
Health Services and Signalling” by Kausik Gupta and Tonmoy Chatterjee build a
theoretical model of services trade, health services in particular, and the role of
quality signalling therein with respect to southern countries. The chapter arrives at
optimum values of health quality and prices of health quality through a two-stage


xiv

Introduction

dynamic game. In Chapter “Smuggling and Trafficking of Workers: A Brief
Review and Analysis of the Economics of Illegal Migration” Saibal Kar surveys the
issue of economics of illegal international migration in general and smuggling or
trafficking of workers. The chapter discusses a policy to lower exploitation from
illegal labour migration. The last two chapters in this part deal with the incidence of
child labour in the context of an open developing economy. Chapter “Impact of
Trade Restriction on Child Labour Supply and The Role of Parents’ Utility
Function: A Two Sector General Equilibrium Analysis” by Biswajit Chatterjee and
Runa Ray shows that non-trade policies are effective to deal with the incidence of
child labour and trade policies remain ineffective.
In Part IV the main focus is on flow of foreign investment, i.e. FDI and FII and
the role of multinationals. Chapter “The Determinants of Foreign Direct
Investment: An Analytical Survey” by Kunal Sen and Chaitali Sinha surveys the
literature on the factors determining the location decision of FDI. It is found that
economies of scale, management skill and innovative product technologies are the

major determinants of location decision of MNCs along with regulatory policies
of the government. The chapter analyses the locational decisions of the southern
MNCs as against those in the advanced market economies in the context of
changing FDI flows in recent years. Both Chapters “Foreign Direct Investment,
Capital Formation and Growth” and “Foreign Direct Investment and
Macroeconomic Indicators in India: A Causality Analysis” concentrate on foreign
direct investment. In Chapter “Foreign Direct Investment, Capital Formation, and
Growth” Prabirjit Sarkar examines the relationship between growth of fixed capital
formation and direct foreign investment (as % of GDP) in a panel of 61 countries
covering a time period of 1980–2006 using alternative methodologies. In Chapter
“Foreign Direct Investment and Macroeconomic Indicators in India: A Causality
Analysis”, Jaydip Mukherjee and Basabi Bhattacharya analyse the pattern of
movement of external capital flows to Indian economy in terms of foreign direct
investment (FDI) and the probable impact of macroeconomic indicators, viz. real
GDP growth, call money rate, US dollar exchange rate, inflation, T-bill rate, trade
openness and Dow Jones Index value on the financial and overall performance
of the economy from the period 1997–1998 to 2013–2014.
Part V contains four papers each focusing on different aspects of globalization
and functioning of financial markets. In Chapter “Exploratory Study of Select
Commodity and Equity Indices Around the Meltdown of 2008” Diganta Mukherjee
and Arnab Mallik conduct an exploratory study of commodity market performance
in and around 2007–2008, when the world was hit by the meltdown resulting from
subprime crisis. Their primary focus is to look into the nature of price movement
and volatility some of the key base metals have been showing, mainly on the
London Metal Exchange and MCX. They also attempt to establish patterns of
movement in some of the popular equity indices and establish which one between
the equity commodities fared well during the period of negative market sentiment in
the years of subprime crisis. In Chapter “An Empirical Investigation of Volatility
Clustering, Volatility Spillover and Persistence From USA to Two Emerging
Economies India and China”, Ayanangshu Sarkar and Malabika Roy examine the

Introduction

xv

pattern of volatility in the Indian and Chinese stock market during 2006–2011 in
terms of its time-varying nature, presence of certain characteristics such as volatility
clustering and whether there exists any ‘spillover effect’ between the domestic and
the US stock markets. They also estimate the persistence of shock in terms of
half-life in each subperiod of study. In Chapter “Imbalances, Local and Global, and
Policy Challenges in the Post Crisis World”, Soumyen Sikdar addresses some
interesting questions on correct policy choices in the face of the economic slowdown that India and China have experienced as a result of subprime crisis. Some
very pertinent questions are: What are the major policy failures that allowed the
catastrophe to happen? What type of reforms will prevent a recurrence? Should
China, India and other developing economies of Asia and Africa make systematic
efforts to ‘decouple’ from the developed countries and work towards greater integration among them? If yes, then how? The chapter attempts to suggest answers to
these questions, after examining the impact on the Indian economy and the role
of the Indian policymakers during the time of trouble. Future prospects of India and
China, the two Asian giants, receive particular attention. In Chapter “Testing Nonlinearity in Emerging and Developed Markets” Basabi Bhattacharya and Koushik
Guhathakurata explore the possibility of non-linearity in selected stock markets
of the world.
In Part VI we have included three papers all dealing with foreign exchange
market, which is a major area of study in international finance. Chapter “Foreign
Exchange Markets, Intervention and Exchange Rate Regimes” is a survey of
structure of foreign exchange market. In this chapter Ashima Goyal describes the
institutional features of FX markets, with special emphasis on the process of liberalization and deepening in Indian FX markets, in the context of integration of
currency markets with financial markets and of large international capital flows.
Chapter “Global Foreign Exchange Market: A Crisis Analysis” is an exploration
of the global foreign exchange market dynamics around the significant financial

meltdowns in the past. In this chapter Gagari Chakraborty studies the factors
influencing the forex market movements over the last 20 years. She further enquires
whether and how the sensitivity of forex market changes, following the changes in
the chosen real and financial variables in times of such crises. Finally, in Chapter
“The Impossible Trinity: Where Does India stand?”, Rajeswari Sengupta addresses
the dilemma of “impossible trinity”. This chapter again is basically a survey
chapter. In this chapter, she presents a comprehensive overview of a few empirical
studies that have explored the issue of trilemma in the Indian context. Based on
these studies she analyses how Indian policymakers have dealt with the various
trade-offs while managing the trilemma over the last two decades and also draw
relevant policy conclusions.
Part VII brings together four studies on financial institutions. In Chapter
“Guaranty Funds and Moral Hazard in The Insurance Industry: A Theoretical
Perspective”, J.M. Gandar, Sumon Mazumdar and C.W. Sealey develop a model
of the guaranty fund insurance company relationship under moral hazard, and
examine the nature of adverse incentives in this setting. They also devise workable
mechanisms that alleviate the moral hazard problem. Rama Seth and Kamran


xvi

Introduction

Quddus, in Chapter “Performance of Aggregate Portfolios of Equity Mutual Funds:
Skill or Luck?” present some descriptive statistics on mutual funds contrasting the
two countries: USA and India. Then they evaluate the performance of mutual funds
in an emerging market such as India, borrowing a methodology extensively used in
asset pricing literature. Next using bootstrap simulations, they analyse the persistence of fund returns, distinguishing skill from luck. The next two chapters both
deal with different aspects of international banking. Chapter “Foreign Bank
Presence and Financial Development in Emerging Market and Developing

Economies: An Empirical Investigation” by Sasidaran G. sets out to explore the
empirical determinants of foreign bank entry in emerging and developing economies (EMDEs). Using panel data for over 100 EMDEs, this chapter contributes to
the literature by throwing light on understanding the motives of foreign bank entry
to EMDEs which remains a relatively under-researched topic in the literature. In
Chapter “Banks, Financial Derivatives, and Crises: A Fourth-Generation Model”,
taking off from the third generation open economy model of financial crisis, Romar
Correa examines the investment plans of domestic entrepreneurs supported by
banks. He models outcomes consequent on changes in capital movements and the
possibility of multiple equilibria.
A unique feature of the proposed volume is that it unravels some new issues in
addition to re-examining certain old issues in a new perspective and it covers wide
ranging issues with an emphasis on policy. The book covers issues mostly related to
emerging market economies, which has increasingly assumed importance in the
context of globalization. The book contains some survey papers covering the
frontiers of current knowledge on important themes like recent developments in
trade theory and empirics, foreign exchange market, interrelation and interaction
between international trade and international finance. The book, thus, will be of
immense use for advanced undergraduate and graduate teaching as well as for
research. We expect the book to substantially contribute to the growing literature on
issues related to trade and international finance in emerging market economies and
extend the frontiers of knowledge. The editors are grateful to the Centre for
Advanced Studies, Department of Economics, Jadavpur University, Kolkata, and in
particular to Ajitava Raychaudhuri and Basabi Bhattacharyy for entrusting them
with the job. The editors are extremely grateful to the authors as well as the
reviewers of the papers for their carrying out their respective duty with responsibility. The volume would not have seen the light of the day without the extreme
cooperation of the editorial team of Sringer India.


Part I

Recent Developments in Trade
Theory and Empirics


The “New-New” Trade Theory: A Review
of the Literature
Priya Ranjan and Jibonayan Raychaudhuri

Abstract We review the literature on the so-called “new-new” trade theory models
starting with the pioneering work by Melitz (Econometrica, 71(6):1695–1725,
2003). We review some of the empirical work that motivated the development
of these “new-new” trade theory models. We provide a survey of the theoretical
literature on the “new-new” trade theory models and give a short account of the
recent empirical work in this area. We also discuss policy implications and welfare
implications of trade liberalizations in the context of this framework.

1 Introduction and Motivation
The development of trade theory has historically been driven by the discovery of
stylized facts in data which required an explanation. “Old” trade theory, confronted
by the empirical results of Grubel and Lloyd (1975) was found wanting in an
explanation of these facts.1 Old trade theory predicted a lot of “dissimilardissimilar” trade–trade in very different types of goods between countries with

By “Old” trade theory we mean the traditional comparative advantage-based models of trade.
Comparative advantage between countries emerges either from differences in labour productivity
due to technology (the Ricardian model) or from differences in natural resources (the Heckscher–
Ohlin Model). Comparative advantage predicts that under perfect competition, if trade is free from
restrictions, countries produce and export those goods that they can make at a relatively (compared
with other countries) lower opportunity cost.

1

P. Ranjan
Department of Economics, University of California, Irvine, USA
J. Raychaudhuri (&)
Department of Economics, University of East Anglia, Norwich, UK
e-mail:
© Springer India 2016
M. Roy and S. Sinha Roy (eds.), International Trade and International Finance,
DOI 10.1007/978-81-322-2797-7_1

3


4

P. Ranjan and J. Raychaudhuri

different resource endowments or technology.2 However, the empirical evidence
found by Grubel and Lloyd showed the prevalence of “similar-similar” trade (or
intra-industry trade)–trade in the same types of goods between countries that are
very similar (see Krugman 2008, p. 336). Krugman (1979, 1980) pioneered the
development of “New” trade theory to explain these intra-industry trade flows.3 The
scope of this new trade theory was expanded to include the earlier traditional
framework, in the synthesis of new and old trade theory by Helpman and Krugman
(1985). However, this new trade theory, in turn, was not found to be broad enough
to accommodate a number of stylized facts, observed in firm micro-data, around the
1990s. To explain these facts the (so-called) “new-new” trade theory was developed, pioneered by Melitz (2003).
Broadly these facts, as summarized in Bernard et al. (2007), are the following4:
(1) Exporting is a rare activity: In any industry only a small fraction of firms
export. Also, exporters sell most of their output domestically.

(2) Exporters are “better” than non-exporters: Exporters are bigger and more
productive than non-exporters (measured using either labour or total factor
productivity) and they pay higher wages than non-exporters.

2

Old trade theory was partially successful in explaining inter-industry trade patterns among
countries. In a notable early study Bowen et al. (1987) use cross-sectional data for 1967 to test the
“factor content” version of the Heckscher–Ohlin model. They use 27 countries, 12 factors of
production and several goods in their analysis. For each country in their dataset, they compute the
country's share of the world endowment of each factor and the country's share of world income.
The Heckscher–Ohlin model predicts that a country should “export” factors (embodied in goods
produced) in which the factor share of the country is higher than the share of the country's income
and vice versa. The authors find (using simple sign tests) that the “… proportion of sign matches
exceeds 50 % for 18 countries, and exceeds 90 % for five countries (Greece, Hong Kong, Ireland,
Mexico, and the UK). However, the proportion of sign matches is below 70 % for 19 of the 27
countries.” (Bowen et al. 1987, p. 796). In other words, the trade flows have the predicted sign
(direction) less than 70 % of the time for most countries in the sample. Later empirical work has
had more success by relaxing some of the assumptions of the Heckscher–Ohlin model. For
example, Trefler (1995) allows for differences in technology between nations and a home bias in
consumption. However, old trade theory assumed away completely the presence of intra-industry
trade.
3
The common thread in Krugman’s models is a simple general equilibrium model of imperfect
competition in a differentiated product industry. The basic assumption is that on the demand side
consumers derive utility by consuming different varieties of a good. This is known as consumers’
“love of variety” for differentiated goods (consumers’ preferences are given by a CES utility
function). On the production side, there is increasing returns to scale which makes it unprofitable
for a single firm to produce all varieties. Under trade, consumers' driven by love of variety,
demand home and foreign varieties of a good. Domestic and foreign firms (identical firms located

either at home or abroad) specialize in producing and exporting only one variety of the differentiated good to take advantage of specialization from increasing returns. So a combination of love
of variety and economies of scale ensures that large volumes of different varieties of a good are
produced by different firms and then traded across countries. Krugman (1980) is a generalization
of Krugman (1979).
4
Categorization of the empirical evidence into these three broad heads and their subsequent
discussion follows the approach outlined in Bernard et al. (2007).


The “New-New” Trade Theory: A Review of the Literature

5

(3) Trade liberalization increases the average productivity level in an industry:
Following a period of trade liberalization average (weighted) productivity in a
industry increases.
Since this empirical evidence played a crucial role in motivating the work by
Melitz (2003) and the subsequent theoretical literature, we now take a closer look at
the empirical evidence for each of the aforementioned points.

2 Stylized Facts in Need of an Explanation
First, let us consider point (1). In their survey article, Bernard et al (2007) report
how rare exporting is. According to these authors, only 4 % of the 5.5 million U.S.
firms were exporters in 2000. Among these 4 % of firms, the top 10 % accounted
for 96 % of total U.S. exports.5 Since in new trade theory all firms are identical by
assumption, it cannot explain why some firms export and others do not.
Point (2) has been documented in very early studies by Bernard and Jensen
(1995, pp. 81–87, 1999) (and reported in the survey by Bernard et al. (2007)).6
They find that exporters outperformed non-exporters along a number of firmspecific attributes. Specifically, exporters are larger, more productive, more
capital-intensive, more skilled-labour intensive and they also pay higher wages. For

example, exporters are 119 % larger (measured in terms of employment), 26 %
more productive (measured in terms of value added per worker), 32 % more
capital-intensive (measured in terms of capital per worker), 19 % more
skill-intensive (measured in terms of skill per worker) and pay 17 % higher wages
than non-exporters.7 Evidence on the better performance of exporting firms has
been documented for other countries as well.8 This feature—of the superior performance of exporters relative to non-exporters—regularly observed in data, is
known as the “export premia” in the literature. Empirical studies have focussed
particular attention on why these “export premia” arise. The critical question (from
an academic as well as from a policy perspective) here is whether these premia arise

5

See Bernard et al. (2007, pp. 108–109).
One of the most comprehensive early studies is the work by Bernard and Jensen (1999) who use
firm- and plant-level longitudinal data (from 1984–1992) from the Longitudinal Research
Database (LRD) of the Bureau of the Census for US manufacturing firms. This database has
detailed information on a number of firm and/or plant characteristics over a range of industries
spanning U.S. manufacturing.
7
See Bernard et al. (2007, Table 3 on p. 110).
8
For example, Aw et al. (2000) report exporter premia for firms in China and Korea and Mayer and
Ottaviano (2008) report premia for both exporters as well as firms engaged in FDI for firms in
Germany, Hungary, Italy, Norway and the UK. Other important studies include Aw and Hwang
(1995), Clerides et al. (1998).
6


6

P. Ranjan and J. Raychaudhuri

because exporting is a difficult economic activity and so only the most productive
firms are up to the task (thus a selection effect is at work) or is it because exporters
learn and grow more efficient by exporting over time (thus a learning effect is at
work). Most empirical results showed evidence for a selection effect, so a firm has
to be highly productive before it can break into the export market.9 By assumption,
all firms in the Helpman–Krugman model are identical and so this theory again
cannot explain why this feature is observed in the data.
Point (3), the increase in aggregate productivity post-trade liberalization,
observed in recent empirical studies, is perhaps the most puzzling. The most
important of these empirical studies is Pavcnik (2002) who considers the effect of
Chile’s trade liberalization, between the years 1979 and 1986, on productivity.
Chile eliminated its non-tariff barriers, reduced its tariff rates and maintained a
strong commitment to free trade in this period.10 Also, the trade liberalization
episode was accompanied by the exit of a number of plants.11 Pavcnik uses a
two-step method in her estimation. In the first step, she uses a semi-parametric
method to obtain consistent estimates of the production function and then uses this
estimated production function to calculate productivity.12 In the second step, she
measures the impact of trade liberalization on the estimated productivity from the
first step.13 Pavcnik uses (continuous) longitudinal data on Chilean plants for
7 years from 1979 to 1986. These plants are from eight manufacturing industries
(two or three-digit ISIC industry-level) which are aggregated for convenience into
import-competing, export-oriented and non-traded groups. To measure aggregate
(industry-level) productivity she constructs a weighted productivity measure with
weights proportional to the plant’s output share in the industry in a year. She finds
that aggregated weighted productivity increased in six out of the eight industries
considered, over her sample period. Moreover, most of this improvement comes
from resource and market share reallocation from less productive to more

Van Biesebroeck (2005) is a notable exception and finds some evidence of learning by South
African exporting firms. Also, Aw et al. (2000) find some evidence of learning by Korean firms.
Ranjan and Raychaudhuri (2011) also find some evidence of learning by Indian firms.
10
Tariff rates were reduced by more than 100 % during 1974 to a uniform ad-valorem tariff of
10 % in 1979. Trade liberalization continued throughout the 1980s except for a brief period from
1983–1984 when tariffs were raised to a 35 % uniform rate in response to a recession but were
then reduced to an uniform rate of 20 % by 1985 (Pavcnik 2002, pp. 246–247).
11
This suggests that the effects of plant liquidation need to be accounted for in the estimation
process.
12
This measure is plant specific and time varying.
13
Pavnick’s methodology deserves mention because it corrects for the simultaneity bias and the
selection bias in measuring productivity. Simultaneity bias arises because a firm’s productivity
(known privately only by the firm) influences its choice of inputs in production leading to biased
measures of productivity using just ordinary least squares regression (to estimate the production
function). Selection bias arises because only those firms that except positive profits continue to
produce and are therefore included in the estimation sample. Pavnick’s semi-parametric estimation
technique based on the method by Olley and Pakes (1996) controls for both of these biases.
9


The “New-New” Trade Theory: A Review of the Literature

7

productive firms. Overall, productivity increase is about 19 % after liberalization
(over the seven-year period). Most of this gain (about 12.7 %) is due to reallocation

of resources from low-productivity firms to high-productivity firms. Also, most of
the reallocation changes occur in import-competing sectors and least in the
non-traded sectors (see p. 262 and Table 3 in Pavcnik (2002)). In Chile’s case, trade
liberalization was accompanied by reforms in other sectors of the economy which
might have biased Pavcnik’s results. The evidence is much more convincing in
Trefler (2004) who studies the effect of CUSFTA (Canada-United States Free Trade
Agreement, 1988) on productivity in Canada.14 Using data on Canadian industries
from 1989–1996, Trefler obtains results similar to Pavcnik (2002). The free trade
agreement leads to an overall increase in labour productivity (not total factor
productivity as in Pavcnik (2002)) in Canada’s manufacturing sector by about 6 %.
Once again, the sectors most impacted are the export-oriented group of industries
(14 % increase in labour productivity) and the import-competing group of industries (15 % increase in labour productivity). Since the Helpman–Krugman model
ignores firm heterogeneity by assuming identical firms, it cannot provide a reasonable explanation for the increase in average industry productivity following
episodes of trade liberalization.

3 The Melitz Model and How It Explains the Stylized
Facts
A number of stylized facts, therefore, remain unexplained by new trade theory.
Melitz (2003) uses these stylized facts to motivate a model of trade where two key
elements—firm heterogeneity in productivity and a fixed cost of entering export
markets—determines the number and the type of firms that become exporters and
the gains from trade. Melitz combines elements from both trade theory as well as
industrial organization theory in his framework. For the trade part, Melitz builds on
Krugman (1980), while for the industrial organization part he incorporates the
dynamic industry equilibrium, set out in Hopenhayn (1992a, b), in his model.15 We
discuss the Melitz model in detail below since it explains a number of the stylized
facts noted earlier and also because this work pioneered the burgeoning literature on
heterogeneous firms. We first discuss the model under autarky and then look at the
effects of trade in this model.

14
Unlike Pavcnik (2002), Trefler (2004) is fortunate in having to consider only the (uncontaminated) effect of a preferential trade agreement between U.S. and Canada.
15
Melitz mentions that his work “…draws heavily from Hopenhayn’s (1992a, b) work to explain
the endogenous selection of heterogeneous firms in an industry” and that his model set up “…
embeds firm productivity heterogeneity within Krugman’s model of trade under monopolistic
competition and increasing returns” (see Melitz 2003, p. 1696).


8

P. Ranjan and J. Raychaudhuri

3.1

Autarky

Melitz (2003) uses the same general equilibrium framework as in Krugman (1980).
In Melitz, consumers are characterized as having CES preferences which reflect
their love of (differentiated) variety for goods as in Krugman (1980) (this elasticity
of substitution between varieties is given by r). Welfare depends on the number of
varieties available to consumers and on the average price level in the economy. The
major difference from Krugman (1980) is on the production side. There are a large
number of firms in the market, each producing a horizontally differentiated good
under increasing returns using labour as the only factor of production.
Heterogeneity is modelled by differences among firms in their (labour) productivity
(or the marginal product of labour), denoted u. Obviously, the higher the productivity of the firm the lower the marginal costs of production.16 All firms share
the same fixed costs of production denoted by f, but because of differences in labour
productivity, have different marginal costs of production. In this economy, there are
an unbounded number of potential firms at any moment who want to enter the

market. However, entry is not free and firms have to pay a sunk entry cost, denoted
by fe , measured in terms of labour, to enter the market.17 Firms do not know their
productivity before entering the market. The productivity levels are assumed to be
drawn by firms from a distribution characterized by a cdf GðuÞ (pdf gðuÞ). Firms
can draw (“discover”) their productivity only after paying the sunk cost fe . So, lowand high-productivity firms can coexist in the market. In this setup, the ratios of any
two firms’ outputs and revenues depend directly only on the ratio of their productivity levels (and the price ratios depend inversely on the ratio of their productivity levels).18 Therefore, in line with the empirical evidence, more productive
firms sell more output, generate higher revenues and make more profits than less
productive firms.19
Active firms may exit the market if they are hit with an exogenous shock (like a
sudden fall in demand) with probability d.20 After a firm draws its productivity from
the productivity distribution, it makes a decision of whether it wants to produce or
whether it wants to exit the market depending on whether its expected value of the
discounted sum of profits (discounted by d) are high enough to repay the initial
fixed entry cost fe . A stationary equilibrium for this economy exists when the

16

So marginal costs are u1 .

17

The sunk cost fe could be the cost of carrying out a market survey or the development cost of a
new variety of a good before the firms actually enter the market.
18
See Melitz (2003, Eqs. 3 and 6, pp. 1699–1700).
19
All of these variables ultimately depend on the firm's productivity. Formally, profits (p) and
revenue (r) depend directly on the firm’s productivity and are denoted pðuÞ and rðuÞ respectively; prices depend inversely on a firm’s productivity and is denoted as pðuÞ. pðuÞ and rðuÞ
also depend on aggregate price and revenue in the economy (defined later).
20

This probability is a constant across all firms and over all periods and is modelled after
Hopenhayn (1992a, b).


The “New-New” Trade Theory: A Review of the Literature

9

number of incumbent firms that are forced to exit in this manner is equal to the
number of firms that are able to successfully enter the market. Melitz defines a
“cut-off” productivity level uà , such that the (marginal) firm with this productivity
level just makes zero expected profits, or pðuÃ Þ ¼ 0 and any firm with u\uà exits
the market. So the productivity cut-off uà is the minimum productivity that ensures
a positive value of profit for the firm. Only firms that draw a productivity u [ uÃ
decide to produce. This shapes the ex-post probability distribution of productivity
for the firms. Since only firms with productivity u [ uà stay in the market, the
actual (ex-post) pdf distribution lðuÞ is a truncated distribution given by 1 ÀgðuÞ
Gðuà Þ.
Therefore, the ex-post pdf of productivity for firms that survive to produce for
the market is derived from the ex-ante pdf of entering firms via the entry–exit
mechanism mentioned earlier.
Now Melitz introduces a number of aggregate variables to make the analysis
tractable in this heterogeneous productivity setup. If there are M firms that actually
produce in the market, then given this mass of firms, it is easy to determine the
values for aggregate variables in this economy like the overall price level P, total
profits P, and total production level for all differentiated goods Q (see Melitz 2003,
p. 1700). Now, instead of dealing with this mass of heterogenous firms, one can
conveniently think of a “representative firm” in this setup. This representative firm
is a firm with a productivity level equal to the weighted average productivity level
of all the surviving firms’ productivity levels (calculated using the aforementioned

ex-post distribution of productivity lðuÞ). Melitz denotes this average productivity
~ . The representative firm with productivity level u
~ earns “average” profits
level as u
, such that the average profit times the
denoted by p
number
À
Á of active firms in this
P 21
¼M
economy gives the total profits in this economy or p
. Similarly, this representative firm will induce (on multiplying by M) the same aggregate price level,
revenue and quantity as the economy with M heterogeneous firms with the ex-post
productivity distribution lðuÞ. Since the ex-post productivity distribution, lðuÞ,
itself depends on the cut-off productivity level uà , the measure of the (ex-post)
~ mentioned above can now be obtained as a function of this
average productivity u
~ ðuà Þ. Using the ex-post productivity distribution, it can be
cut-off uà denoted by u
shown that average profit, average revenues and the average price level are also
ultimately determined by the cut-off productivity level (see Melitz 2003, p. 1703).
Of these variables, the most important variable that is subsequently used is the
, which can be denoted as a function of the average productivity
average profit p
~ ðuÃ Þ or as p
½~
u
uðuà ފ.
Two key relations are then used to endogenously determine the actual values of

 in the economy. The first
the cut-off productivity level uà and the average profit p
relation is the zero-profit cut-off condition (or ZCP) and the second is the free entry
 and uà .
(FE) condition. The ZCP condition gives a negative relation between p
Note that since all firms that are active in the market earn positive profits (except the marginal
 must be positive. Positive profits attract
firm that earns zero profits) the average level of profits p
firms to the industry.
21


10

P. Ranjan and J. Raychaudhuri

When the cut-off productivity uà increases, two opposing effects come into play.
Each surviving firm is now more productive since the cut-off survival productivity
level is higher. Since average profit is a function of cut-off productivity level,
average profit has a tendency to increase. But by the same reasoning, all the other
surviving firms that have productivity levels higher than the now increased cut-off
productivity level are also now more productive. Therefore there is more competition among firms for profits, which causes average profits to decrease. Under some
mild assumptions on the probability distribution GðuÞ, the second effect dominates
the first effect giving a net negative relation.22 The FE condition gives a positive
 and uà . The FE condition states that in equilibrium the expected
relation between p
value of the future stream of profits for a firm should be equal to the fixed cost of
entry so that the net value from entering the market is zero. As the cut-off productivity increases, fewer firms will be able to enter the market. The entering firms
will be higher productivity firms that will earn higher profits leading to higher
average profits (conditional on entry).

In the (p, u) space, the positively sloped FE and the negatively sloped ZCP
 and the equilibrium
curves intersect once giving the equilibrium average profit p
cut-off productivity uà in autarky. To close the model, Melitz uses a labour market
clearing equation. In Melitz as in Krugman (1980), labour is the only factor of
production which is used either for production or to pay the fixed costs of entry. As
labour is the only factor of production, all income accrues to labour and therefore
total income equals total expenditure on differentiated goods by labour-consumers.
 and uà derived earlier and the labour market
Using the equilibrium values of p
clearing condition, Melitz determines the number of varieties/firms, total output,
aggregate prices and welfare. With wages of labour normalized to 1, welfare is
inversely related to the aggregate price level.

3.2

Trade

Now Melitz considers the effects of trade in this economy. He assumes that the
economy under study begins to trade with n ! 1 other countries. If trade costs are
absent, then under trade, equilibrium would just mean a proportional increase in the
scale of this economy without any effect on a firm’s revenue, profits, etc. However,
Melitz introduces iceberg transport costs a la Samuelson (1952) denoted s [ 1
which is the amount of any variety that a firm has to produce in order to ship 1 unit
of a variety to a destination. More importantly, he also adds a fixed cost of
exporting, denoted as fx , which is a lump-sum cost to start exporting and which is

22

Formally, as noted in Melitz (2003, p. 1704), a sufficient condition for the ZCP to decrease is that

should be increasing to infinity on ð0; 1Þ—an assumption which holds for many
probability distributions.

gðuÞu
1 À GðuÞ


The “New-New” Trade Theory: A Review of the Literature

11

paid only after the firm learns about its productivity.23 Since exporting is costly
there is a further selection of better-performing firms into the export market.
Further, since firms can decide to export only after drawing their productivity from
gðuÞ, all exporters sell their goods in the domestic market but not all firms in the
domestic market can export. Melitz defines another productivity cut-off, denoted as
uÃx , such that firms with productivity levels above uÃx earn profits from selling in the
domestic market and these firms can also earn profits from exporting the goods to
the foreign market.24 Firms with uà \u\uÃx produce exclusively for the domestic
market. Melitz shows that this partitioning of firms—into firms producing exclusively for the domestic market, and firms producing for both domestic and foreign
markets—is only possible under the condition that the fixed costs of exporting (fx )
are sufficiently high.25 Since uÃx [ uà only the most productive firms export. Under
trade, Melitz recomputes the ZCP and FE conditions for the integrated market.
The FE condition remains unchanged but the ZCP curve shifts upwards since the
firms that survive on average make higher profits. Therefore, the cut-off productivity level increases under trade.
Melitz now considers the implications of trade on the allocation of market shares
and profits among firms and on aggregate productivity. Comparing autarky with
free trade, he shows that post-trade the least-productive firms leave the domestic
market (a domestic market selection effect) while high-productivity firms enter the
export market (an export market selection effect) and these two kinds of selection

effects work to drive market shares towards more productive firms. The mechanism
through which these effects operate is the following. Under trade, all firms suffer a
loss in domestic sales (Melitz 2003, p. 1714). This causes the least-productive firms
to exit the market as they are unable to earn positive profits. However, exporting
firms make up for the loss in domestic sales with foreign sales. These firms increase
their production to exploit the opportunity of earning additional profits from exports
and hence increase their demand for labour. Demand for labour from these new
exporters increases the overall demand for labour in the economy and causes a rise
in the real wage. As a result of this increased wage, some of the less-productive
firms that were just breaking even, now make losses and are forced to exit the
market.26 The net result of these selection forces is a reallocation of market shares
from low-productivity firms to high-productivity firms leading to an increase in the
average productivity of this economy. Melitz recognizes that this mechanism “…
highlights a potentially important channel for the redistributive effects of trade
within industries” (Melitz 2003, p. 1716). He notes that such a restructuring of the
Examples of such costs include fixed costs like the cost of setting up a distribution channel in a
foreign market, or informing foreign consumers about a product, or a production cost incurred to
modify home products for foreign consumption or to confirm to foreign regulatory standards.
24
Exporters are also more productive and bigger as a consequence of the higher productivity. This
is in line with empirical evidence.
25
Formally, this condition is srÀ1 fx [ f . A large fixed cost of exporting will give fx [ f and lead
to this partitioning.
26
See Sect. 7.2 in Melitz (2003, p. 1715).
23


12

P. Ranjan and J. Raychaudhuri

economy might have contributed to the increase in productivity in U.S. manufacturing reported in Bernard and Jensen (2004). So, the model is also successful in
explaining the increase in post-liberalization productivity observed in the data. In
sum, therefore, the Melitz model explains quite a few stylized facts observed in the
data that could not be explained by new trade theory.

4 Subsequent Research
The Melitz model has initiated a large literature which explores the implications of
incorporating firm heterogeneity in a number of different setups. In the paragraphs
below, we discuss some of the main extensions/applications of the Melitz framework. Since the literature following Melitz is quite extensive, we select only the
direct and most important extensions/applications of Melitz’s framework. We
consider in the paragraphs below three important extensions: (i) the extension of
Melitz to cover the case of internationalization of the firms via FDI (Helpman et al.
2004) (ii) the extension of the Melitz framework to consider the effect on trade
flows following the removal of trade barriers (Chaney 2008), and (iii) the extension
of the Melitz framework to explain certain features of the bilateral trade matrix,
thereby leading to a more precise gravity equation (Helpman et al. 2008). We also
mention some of the other related literature and a model that has been developed as
an “alternative” to the Melitz model.
We start with Helpman et al. (2004) who extend the Melitz framework to include
FDI and trade. They answer the question of the mode of foreign market access in
the Melitz setup, that is, why some firms become exporters and why other firms
choose to serve foreign markets via FDI. In their model, in any sector there is a cost
of market entry fE , a cost of production in the domestic market fD , a fixed cost of
exporting fX (for each foreign market), and there is also an additional fixed cost of
FDI given by fI . Unlike in Melitz, the marginal costs of production are the same for
all firms. Their critical assumption is that fI adjusted for relative wages wi and wj in
two countries i and j) is greater than fX adjusted for trade costs sij between countries

i and j which in turn is greater than fD (see Helpman et al. 2004, Eq. (1) on p. 302).
This condition ensures that firms sort themselves into a hierarchy—the
least-productive firms exit the market altogether, low-productivity firms produce
only for the domestic market, more productive firms absorb transport costs and
export to the foreign market and the most productive firms incur the fixed FDI costs
to set up a subsidiary in another country and become MNEs.27 The authors compute
the productivity cut-offs at which these entry mode switches occur and then they
take their model to data.28 Their empirical analysis is conducted at the sectoral level

27

Using the COMPUSTAT database for the US for 1996, Helpman et al. (2004) show (Table 1 on
p. 301) that MNE's are 15 % more productive than even exporters.
28
Helpman et al. (2004, p. 303, Eqs. (2)–(4)).